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Thursday, November 3, 2011

Just This Once, I Promise!

Companies are required to release their financial results according to GAAP. Often, however, companies will also release what they call "Pro Forma" statements, where certain "one-time" costs are often removed. These statements, managements say, better reflect the earnings power of the company. However, investors are urged not to take managements word, but rather to consider the "one-time" costs to make their own determinations as to whether these apply in the future.

For example, managements have often excluded early plant retirement costs or losses on the sales of equipment from pro forma statements. While these items may not occur annually, the investor must apply business sense to determine if these are likely to re-occur.

For example, does the company compete in an industry rife with technological change? If so, early plant retirements may be part of the cost of doing business. Does the company often have to sell equipment below book value? Management may be using a depreciation schedule that makes earnings look higher than they should be.

The best way to include non-recurring yet real business costs is to average out several years worth of earnings, as discussed in Chapter 37 of Security Analysis by Ben Graham and David Dodd.

As an aside, many companies have also used pro forma statements to exclude the expensing of stock options, which is now required by GAAP. As we discussed here, options have real value, and to avoid expensing them misleads investors about the true costs of operating the business.

The term "one-time costs" suggests investors need not concern themselves as these are unlikely to re-occur. Unfortunately, in many industries and companies, "one-time" costs are the norm rather than the exception. As such, investors need to strongly consider and account for the items that managements suggest should be ignored.